Whether you like the recent healthcare bill or not, it is now law. What does it mean for you?
Honestly, I have no idea. This week we’re going to break it down, but we’re going to do it differently than you may have read elsewhere. After that we’ll do a quick market recap and sign off ‘till next week, when we will be making a biiig announcement here at The Draconian. I almost can’t wait!
Healthcare Reform is here! (?)
We should begin by accepting that this is a very partisan issue. Democrats wanted this thing passed and Democrats passed it. Republicans didn’t want it, and they didn’t vote for it. I’ve also noticed that most people tend to have very strong feelings about it one way or another. Ordinarily, I wouldn’t find anything strange about that. But my guess is that few of these people really understand the mechanics of this legislation which makes me wonder where all the strong feelings come from.
I checked it out on OpenCongress.org. The bill is 2,393 pages. Do you understand how this reform works? I mean, beyond the talking points and political spin. Seriously: how confidently can you speak about the details of this thing? I’ll leave that for MSNBC and Fox News.
I feel like the only way to really add value to the conversation about health insurance reform is to look at things from a slightly different perspective, and we’re going to try and do that today. We’ll see if we can get above the political, emotional, and philosophical fray, and figure out just what the heck is going on here. From an investment context, of course.
I always like starting with charts:
This is a chart of the IHF, which is a healthcare ETF. It’s comprised of companies like UnitedHealth, WellPoint, Aetna, and Quest Diagnostics, so it’s a good proxy for the sector. It has outperformed the market by about 25% over the last 6 months.
When Scott Brown got elected and it looked like healthcare reform was dead in the water, this thing sold off. But Obama got back out there and pushed Congress to make it happen and since then, it’s been straight back up.
What does that mean?
Well, it means that the market – an entity that speaks without any kind of political bias – thinks that healthcare reform is a good thing for these companies. The market thinks that this epic legislation will make these companies more profitable.
That might be OK. With more profits these companies can hire new workers and spend more money on all sorts of other stuff like technology providers. For whatever reason, “corporate profitability” has a tendency to upset certain folks, but really it’s not so bad. When companies make money a lot of people benefit beyond the board, the CEOs, and the shareholders.
You might be thinking, wasn’t this supposed to reform the healthcare industry and insurance companies? Why are their stocks going up? Wasn’t this supposed to make life more difficult for them and better for us?
Well, the insurance industry isn’t stupid. It’s also very powerful and very influential. We joke about lobbyists and special interest groups having “purchased” Congressmen and Senators, but it’s sort of true. The healthcare and insurance industries have spent about $1.5 billion on lobbying their interests in the last two years. No way is this gigantic industry going to allow “health insurance reform” without getting something out of the deal. And what they get is a whole lot more customers. Judging by their stocks’ reaction, the benefit of a whole lot more customers clearly outweighs the costs of any ways that this legislation screws reforms their business.
Ideals are at the core
One of the most interesting things to emerge from the debate of the last few years is an increasingly passionate view that healthcare should be a public good i.e. everybody should have some form of health insurance whether it is provided directly by the government or gives heavy subsidies and tax breaks to those that can’t afford it. This seems to be the raw ideal at the core of this legislation, to bring healthcare coverage to one and all.
This idea emerged from the left. Amidst all the cries of “Healthcare for everyone! Healthcare is a right!”, I wonder sometimes if these voices – some of whom are far enough left to qualify as socialists or populists – understand how ridiculously awesome that is for insurance companies. I mean, they don’t give health insurance away for free. Nobody sells insurance because they expect to lose money on the deal.
Who pays for all these new customers? Well that’s easy. You all read the newsletter from a few weeks ago on incomes and taxes, and so you know that as with any government expense, most of the tab will be picked up by those with higher incomes. There also appear to be a few new tax increases in this bill specifically targeting the wealthy. A new 0.9% & 3.8% Medicare tax on joint incomes over $250,000 is one. This item in particular will affect 4 million people, almost none of which will experience any marginal benefit in their current coverage.
In general, the wealthy will be paying to provide health insurance for the poor and uninsured as they always have. That makes it, by definition, a welfare program (a transfer of wealth from one population to another). I know you all feel differently about the concept of welfare programs, and so we’ll avoid any kind of judgment or assessments here. Instead, we’ll ask a broad question:
Is society as a whole made better off?
Are the poor and underinsured made better off by an amount greater than which the wealthy are made worse off? It’s tough to say and impossible to measure, but my gut, speaking as a social scientist, says “probably.” I’m reluctant to get too enthusiastic about it, though. Do any of you wealthy folks feel warm and fuzzy inside for effectively giving health insurance to those who can’t afford it? I doubt it. Do any of you poor or uninsured feel thankful to the rich for enabling you to have health insurance where you didn’t before? Again, doubtful.
I’d feel a lot better about the whole thing if that psychosocial dichotomy didn’t exist.
Badly aligned incentives
One thing I think we’d all agree on, Democrats and Republicans, is that the healthcare and insurance system is a gigantic mess. Even after the passage of this legislation, I think we all agree that it’s still pretty darn messy. I’ll state up front that I don’t have the solution to the problem, nor is it even my area of expertise.
The thing that concerns me the most about this healthcare legislation is that it none of it seems to properly address the fundamental flaw that’s at the heart of this entire disaster.
There is still a major fundamental misalignment of incentives. In nearly all cases, the majority of the costs of healthcare are borne by somebody other than the guy reaping the rewards. On top of that, the guy who uses his health insurance to pay for his medical care usually doesn’t even pay for his insurance policy.
To me, this is bonkers. If I don’t pay for my own insurance plan and receive it as a “benefit” from my employer or the government, what incentive do I have to shop for a good deal? And if my insurance company pays for most of the expenses once my deductible is satisfied, why do I care about how much medical procedures and drugs cost?
A structurally similar scenario is one where you drop your 15 year old daughter off at the mall with your credit card and instruct her to purchase a couple of new outfits for the school year. Do you think she’ll spend more on her new wardrobe than she otherwise would if you dropped her off with $200 cash, the same mandate, and the freedom to keep any money she didn’t spend?
Now imagine a mall full of retailers who know that the only people shopping at their stores will be 15 year olds with their parents’ credit cards. What do you think these retailers will do with their prices in this situation? If their shoppers don’t care about how much they spend, why do they need to price their products competitively?
Democrat/Republican. I’m sure both of your answers are the same.
A mall that only allows 15 year olds with their parents’ credit cards inside is a recipe for disaster. I mean, it’s a disaster if you’re the parent with the credit card. It’s downright awesome if you’re one of the retailers!
And unfortunately, the world we live in is one where those retailers (the health insurance companies and medical providers) have much stronger influence on the folks that make the rules than you or I (the parents). The only sense I can make of it is that the people who designed this legislation don’t understand market dynamics. Or that they do, and wish to avoid them.
There’s a nice conspiracy theory for you.
Investment Context
Back to the investment ramifications, what sense are we to make of all this?
Well, I think it’s pretty safe to say that this should be good for the entire healthcare industry, from top to bottom. A while back I saw a study that the healthcare sector was the only sector to outperform the broader market in the 80’s, 90’s, and 00’s. Will it do it in the 10’s? As much as I hate to forecast linear trends that go on indefinitely, it will probably be the case. For those who hold a portfolio of equities, overweighting healthcare stocks isn’t such a bad idea, especially if you’re a little more risk averse.
You don’t have to be a brain surgeon to figure out that if we are collectively spending a greater percentage of our incomes (either directly, or indirectly via our taxes) on healthcare, it stands to reason that this is an area that should outperform other parts of the economy. It also doesn’t take a degree in brain surgery to figure out that there’s only so much collective income in the economy to be spent on stuff, absent increased borrowing. So increased spending in one area will come at the cost of reduced spending somewhere else.
Which sectors, you ask? It seems like I’m perpetually hating on consumer discretionary stocks, but discretionary stuff is always the first place we cut back in our household budgets, right? Also, the U.S. has very clearly adopted the Japanese Zombie Bank Model, so I fully expect financials as a whole to underperform for a decade or so, but to do it with more annual volatility than a guy like me is comfortable with. If we walk away from our mortgages or renegotiate principal balances, that hurts the banks but it gives us more money to spend elsewhere.
Remember, this isn’t 2005 anymore. Back then, if we were forced to spend more on one thing we could just withdraw money on our HELOC and credit cards to sustain spending elsewhere. It never ceases to amaze me how many people have forgotten how powerful an economic tailwind credit expansion was in the last two decades. Last week we talked about how a lot of things haven’t changed, but this is one thing that has. The era of easy credit is over. It isn’t brain surgery.
And on the subject of brain surgeons, my wife works as a PA, which means she spends a lot of time hanging out in the doctor’s lounge at the hospital. I know it’s anecdotal evidence, but she tells me that nearly all of the doctors she talks to disapprove of this healthcare legislation. Unfortunately, since it’s not actually me talking to them, I haven’t been able to discern secondhand whether their opposition is due to specific ways in which this legislation harms them and their practices, or if they, as higher-earning individuals who tend to lean to the political right, are simply reacting along party lines. In all likelihood, it’s probably a little of both.
Please, if any of you doctors feel like you could add some value to the discussion, I would love to hear it at Feedback@TheDraconian.com. Doctors are one of the groups at the center of this storm and I’m curious to get their perspective. Perhaps we’ll revisit this topic next week or in the weeks to come.
Market Recap
The market doesn’t want to go down. And why should it?
The ugliest of it is behind us. Things aren’t going to get worse. The recession is over and GDP isn’t going to contract anytime soon, nor will the unemployment rate rise by much. Thanks to all the government stimulus, GDP growth was pretty good last quarter and probably will continue to be good for the first half of 2010. But even the most rosy economic forecasts I look at are building in a much smaller figure for the second half of 2010. And 2011 is likely to be a different story. I think the “double dip” recession talk starts to heat up in Q4 of this year after we get what is likely to be a sluggish Q3 GDP number. Remember that the market lives in the future, so look to the market to confirm any double dip talk.
Right now, the market is saying “no double dip in 2010.”
Currently, we’re in a cyclical bull market against the backdrop of what I believe is a long-term bear market (or flat). You may also have heard me describe the secondary trend in the market as bullish against a primary trend that is bearish.
Mohammed El-Erian, CEO of PIMCO, the folks that coined the term “new normal,” described the present market as one that’s being propelled by very powerful cyclical tailwinds but faces strong structural headwinds further down the road. It’s the same basic macro view.
Investors right now need to build two things into their expectations. The first is to expect some volatility over the short-run. You can bet your bottom dollar that another 5-15% correction is somewhere in our near future. Something will swirl seemingly out of nowhere (like Dubai or Greece) and send the markets into a tizzy. For folks that aren’t in the market and want to get into the market, that’ll be a nice entry point. Warren Buffet always says to buy when there’s blood in the streets, so whatever you do, don’t buy during times of ridiculous complacency with the VIX under 17 (pre-Bear Stearns levels!) and with the market up something like 22 days in the last 25. Be patient. The market never moves in one direction forever.
The second things investors need to be aware of is that equity returns over the coming decade are going to be pretty weak. But that’s like, my opinion. You should know, though, that it isn’t just a willy-nilly guess. I buy into the forecast of the “new normal”, an environment that’s dominated by domestic deleveraging, sluggish spending and job creation, and generally slower GDP growth than we’ve all enjoyed in the last two decades. That kind of world is usually pretty bad for equities, with “mediocre” as the upper bound. Go back and take a look at a chart of the 1970’s.
As a whole, I think it’ll be a tough decade for the average investor. But we’ll have some years (like 2009) where it will be like shooting fish in a barrel and anyone who buys stocks will make money. Enjoy them, but don’t fall asleep during those years.
Pretty much all of the money we have is invested in the hedge funds that we manage, but The Draconian is here to help the rest of you stay awake get through the dicey patches.
This week we’re going to look at regulatory reform from a slightly different perspective. We’re going to try and brush away some of the clouds and back way up to look at the big picture. It can be tough to get your bearings when you are a suffocated by such a detailed fog, but today we’re going to call on the help of a few greats.
This newsletter goes out to a bunch of baby boomers and once-hip Gen Xers, so I’m sure there are at least a few Bob Dylan fans out there. Those of you who are might be able to guess where I’m going with this issue after seeing the title. If you’re not a fan, you can listen to the song here.
I’ve heard All Along the Watchtower no less than a million times over the years, and it still gives me goosebumps every time I click play:
Bob Dylan, All Along the Watchtower
“There must be some way out of here” said the joker to the thief
”There’s too much confusion”, I can’t get no relief
Businessmen, they drink my wine, plowmen dig my earth
None of them along the line know what any of it is worth.
“No reason to get excited”, the thief he kindly spoke
“There are many here among us who feel that life is but a joke
But you and I, we’ve been through that, and this is not our fate
So let us not talk falsely now, the hour is getting late.”
All along the watchtower, princes kept the view
While all the women came and went, barefoot servants, too.
Outside in the distance a wildcat did growl
Two riders were approaching, the wind began to howl.
It’s among the most covered songs in the history of pop music so I’m sure you’ve heard somebody sing it, whether it was U2, Dave Matthews, or your favorite local garage band. I prefer the soulful Dylan original, but I enjoy rocking out to the more-famous Hendrix version as much as the next guy. Personally, I think the song has endured the test time of time because it is about time itself.
Go through those eerily apocalyptic lyrics again or sing them in your head. Now read through it backwards.
Brilliant, huh? The tale literally ends as it’s beginning, verses unfolding in reverse chronological order.
I think this is why I prefer the Dylan original, which runs a scant two and a half minutes. Just as the song really gets going, it stops. My first reaction is always to immediately queue it up again. And I’m sure I’m not the first person to ever do that. I’ve read music critics describe Dylan’s manipulation of linear time in this song as “audacious” and “lyrically bold.” Whatever. I just think it’s downright observant.
Life moves in cycles, many of which are almost too broad or too subtle to notice. More often than not it’s the reflective poets like Bob Dylan that pick up on this kind of stuff, not the average trader on Goldman’s prop desk, fixated solely on where a buck can be made in the next few days or weeks.
It shouldn’t surprise you to learn that the markets – themselves driven by cycles of psychology and culture – move in broad patterns as well. Subtle ones, too. The financial crisis shocked everybody, but it shouldn’t have. I realize that when we and our industry peers were all doing battle inside the belly of the beast, the last thing on our minds was historical context. But none of us saw that until well after the fact. In the midst of the chaos, we were all overwhelmed with short term tactics and damage control. Even if you don’t work in finance, it was probably similar for your industry.
But today, two years since the failure of Bear Stearns and a year since the bear market bottom of March, it seems fitting for a more philosophical, introspective look at how the recent past fits into the grand scheme of things.
It’s time… for another Michael Lewis book!
I haven’t read The Big Short yet, but I will. As soon as they make it available for Kindle. (In the meantime, The Draconian is available on Kindle right now! Check it out and write us a brief review.)
Michael Lewis is one of the great chroniclers of our era and has the enviable knack for telling complicated stories from insider perspectives in a manner that is both accessible and entertaining. I suppose that makes him a hero of sorts for a guy like me. Not only is he an inspiration, but he keeps me humble. I often wonder just how mortal amateurs like myself even fancy themselves writers with wizard-poets like Lewis running around, spinning intricate yarns with a brief incantation and casual flick of the wrist.
During the week of the book’s release there has been a flurry of hype in the financial press and even the mainstream media. I don’t watch TV so I missed the interview on 60 Minutes. You may have as well, but fortunately guys like us can view the whole thing right here on the web. I implore you to check it out. I bet you’ll agree that he seems to have figured out the angle that history is now going to run with. Be there for the start of that movement.
Again, you can watch the whole thing for free. Here’s an excerpt:
I’m afraid that our culture will come to the conclusion that everybody was just a bunch of criminals. I think the story is much more interesting that that. I think it’s a story of mass delusion.
[On Wall Street,] people see what they’re incentivized to see, what they want to see. If you pay someone not to see the truth, they will not see the truth.
This is exactly what I’ve been talking about. The financial crisis is part of a far bigger story. It isn’t just a tale of collateralized debt obligations and subprime mortgage-backed securities. It’s a story of psychology. It’s a story of a people and a culture – not just on Wall Street but all throughout America – that convinced itself to believe in an alternate reality. Wall Street was the center of the storm because it was the place where things were denominated in the largest dollars.
Many months ago I wrote about the cultural reaction to the financial crisis and how we should all keep an eye on it. Books like Lewis’ are the sort of reactions that I’ve been looking for. So is the forthcoming sequel to Wall Street. My feelings about Oliver Stone can best be described as “mixed,” but I am having a hard time containing my enthusiasm for this one:
Tell me that new trailer doesn’t look awesome!
Somewhere in the mess of the last few years is a very human story. It is one that has been told before, and has probably been getting told since the dawn of society. Actually, you don’t even need to go back to the dawn of society. The simple fact that we’re getting another Wall Street movie two decades after the original should tell you everything you need to know.
Nothing. Has. Changed.
Not really. Sure, the details are a little different but when you brush that fog away, there isn’t much new. I am reminded of the moving, thoughtful finale to Battlestar Galactica, one of the great gifts to science fiction fans everywhere. During the coda as Baltar and Six walk down the street 150,000 years in the future (past?) and comment on the decadence and commercialism of modern Earth, I was left with the overwhelming feeling that this has happened before and this will happen again.
Folks, this is the story of the markets. The real story. You didn’t think you’d find it on Battlestar Galactica, but there it was if you had your eyes open.
It has all happened before and it will all happen again.
Everybody forgets this, tricking themselves with all sorts of delusions about linear history. And this is exactly what disturbs me. As I watch that Michael Lewis interview and observe what’s going on from my own humble perch in the industry, it’s obvious that nothing has changed. I mean, it is ridiculously, painfully clear to me that none of these fundamental issues with bad psychology and misaligned incentives have been resolved.
We all see that, right?
Government regulation is still shaped by the big businesses it’s designed to regulate, and ratings agencies are still paid by the companies whose debt they are supposed to rate.
The very people who helped engineer the disaster are still the ones we’re asking to help clean up this mess.
We’re all greedy buggers, but Wall Street is still where those with the least shame about it tend to aggregate.
Individuals who have an incentive to act or think a certain way still act and think a certain way, whether it’s an investment banker recommending a dangerous merger or a realtor recommending you buy a house that’s falling in value.
The average guy on the street still doesn’t have an understanding of what really goes on in finance and is much more easily swayed by emotionally-charged political rhetoric.
I recognize that progressive change takes time. But the direction that change seems to be heading is locked entirely on the details of the recent crisis and have nothing to do with the bigger picture that drove them. A year ago I thought it would be impossible for us to return to an environment resembling the pre-crash days, not with an angry public, a shell-shocked banking industry, and authorities hungry for re-regulation. But when I look around today, not only is a return to the good ol’ days on Wall Street possible, it appears rather likely.
I’ve heard this song before.
The test of time
With all due respect to books like This Time is Different and Andrew Ross Sorkin’s Too Big to Fail, I don’t think their material will endure in popular culture. Don’t get me wrong, these are important books, but these stories are about the technical nitty gritty. That may seem really interesting right now as we sift through the wreckage, but it isn’t going to withstand the test of time. Not the way Michael Lewis’ books have, and certainly not the way All Along the Watchtower does.
Why? Because those works are about more than just what happened. They’re about fabric of humanity, its psychology, and how that shapes broader culture. They are about all of us.
I’m sure there was plenty of literature published about the political and financial details of the 1929 crash and subsequent Great Depression. Keynes and Galbraith did have some very important and popular things to say about it after all, but my guess is that you’ve probably never read any of it. Most of that stuff has been lost to history, occasionally dug up under the light of a blue moon by sleepless econ students, quietly compiling data for their doctoral theses.
Instead, this is what the rest of us remember, the photography of Dorothea Lange:
Take a moment and think of some books and movies from that era that have endured? Which ones have withstood the test of time, the ones we go back to again and again?
We read The Great Gatsby, Brave New World, and The Grapes of Wrath. Over and over, we watch Citizen Kane, Mr. Smith Goes to Washington, and It’s a Wonderful Life. My personal favorite is the noir of the 40’s and 50’s, gritty, hard-boiled stuff that was crafted by individuals whose early values were forged during the dark times.
These are the stories that we will hand down, and many are the same basic stories being told today. They are timeless tales of decadence and delusion. Stars that burn bright and then supernova. Pride, entitlement, and the hope of the common man. Oh, and Good vs. Evil, especially if it isn’t always clear which is which. There’s a reason all that film noir was shot exclusively in black & white.
I feel good about Lewis’ chances for surviving the test of time. Liar’s Poker is now twenty years old and it’s the first destination on the list of places to visit to get a feel for what Wall Street was really like back in the 80’s. Twenty years from now it’ll probably still be destination number one.
For the recent financial crisis, others artists will come along too and make their mark on history. I think last year’s Up in the Air is another entry in canon of works to come that will tell the enduring story of the Aughts. Who knows who’ll be next.
I hope it’ll be Philip Roth, the greatest and most prolific writer of the 20th century. (Yeah, I said it. Come back in 50 years ye fans of Fitzgerald, Joyce, Steinbeck, Faulkner and Hemingway and tell me you don’t agree. And I’m not even Jewish!) Kurt Vonnegut or Hunter S. Thompson would have eagerly taken up this sort of task, but alas, they’re covering the story from a wholly different place. But someone will come along and write something that touches us all, and this is what we’ll remember a hundred years from now. Maybe Cormac McCarthy already did that with The Road.
The problem is that these works won’t have any of the details, just the themes and metaphors. Only those who know how to decrypt the meta-messages and translate them to the world around us will have a clue when all of this happens again. This is why I send this newsletter to people that majored in English Lit.
The details will differ next time, but it’ll be the same, you know?
It is all connected
I guess what I’m really trying to say is keep your eyes, ears, and mind open.
I realize this newsletter requires you to indulge me on many occasions. And so I thank you for patiently trundling along on what isn’t always the most clear-cut path through the forest of finance. Like the rest of you, I’m doing this without a map of what lies ahead and I apologize for the times we get stuck in the brush and scratched by the nettles.
Perhaps this journey is more of a crusade. In my professional life, I am surrounded by incredibly sophisticated financiers, staggeringly intelligent minds who simply don’t want to talk to me about the most culturally important books & films to emerge in the last decade or the latest Yo La Tengo album. And in my personal life I am surrounded by brilliant observers of culture, media, and literature. Many are well-versed in history and psychology. I say “interest rates” and “GDP” and they zone out or let slip a sigh of resignation. Sometimes they get angry.
But imagine if a guy like Bob Dylan was an investment banker. I can only wonder about what sorts of interesting things he have to say…
Look: there is real value in bringing these disciplines together. It is all connected, all part of the same tapestry.
And just what does it all mean?
We’ve been asking ourselves that question for thousands of years. I sure as heck am not going to answer it for you here in this obscure and insignificant corner of the publishing world.
I suppose we all have to do it on our own, and as always, we must start by looking within. While you’re doing that, queue up All Along the Watchtower.
This time, listen to that ghostly harmonica and the inevitable sense of doom carried on the chords of Dylan’s guitar.
And the end that catches you out of nowhere.
This week we’re going to talk about Crude Oil and what it will mean for your checkbook this summer.
But first, we’ve got a huge announcement. You can now subscribe to The Draconian through Amazon.com and have it delivered straight to your Kindle!
Full disclosure:
- I own a Kindle and love it.
- We don’t set the price. Amazon set it at $0.99 per month and you can subscribe free for 14 days. We get 30% of the total revenue and Amazon gets the other 70%. I have no experience with print publishing, so I have no idea if this is appropriate or if I’m getting the shaft. Either way, this won’t exactly be a road to riches for our business and if I had my way, I’d just make it free.
But if I’m not providing you 99 cents of value with four newsletters each month, I should probably fire myself and go get a job at Goldman Sachs. I hear those guys pay their employees, um, pretty well.
This newsletter will always be free via e-mail and the website. If you own a Kindle you probably know right away if it’s worth it to pay $0.99 per month to have a magazine or blog delivered straight to your device where you can read it in bed at night, take it on the plane, or relax with it by the pool.
I’ve been subscribing to our Kindle newsletter myself, mainly to just test out the functionality. And I’ve found that The Draconian is surprisingly well suited for the Kindle. Our newsletter runs a little longer (brevity is a perpetual struggle for me) and requires a little more focus and intelligence than TMZ or Jim Cramer. I also subscribe to Fortune Magazine on my Kindle and I enjoy sitting down with this kind of content in my comfy chair and sorting through it in peace and quiet. It’s nice to physically remove myself from the myriad other distractions on my computer.
Whether you have a Kindle or not check out the Amazon page. If you’ve enjoyed The Draconian so far then leave a quick review, or at the very least, mark the existing reviews as being helpful. Helpful customer reviews are a big part of why I enjoy shopping on Amazon.com.
Like I said, there’s a free two week trial, so it’s not like there’s any risk involved.
Click here if you’re a Kindle owner to head over to Amazon and download some free trial issues.
Now to the markets…
Too few eyes on Crude
Not a lot of people are paying attention to oil right now. The whole world was tuned in back in 2007 and 2008 as it soared above $100/barrel and on to $145/barrel. Everybody was talking about the long term supply & demand picture for oil and the hottest trends were “going green” and buying a hybrid. Today you can insert one of countless Prius jokes [here].
But things on the energy front have actually gotten worse since then. There has been basically zero serious investment in alternative sources in the last year or two. On top of that, crude oil is now trading a little north of $80 per barrel, which is where it traded back in October 2007, the peak of the last massive global growth cycle.
Despite the fact that we’re mired in an economic slump – the “new normal,” if you will – crude is still trading at $80 per barrel! I find this fact remarkable. I mean, just how bleak is the future of traditional energy sources?
I agree with George Friedman of STRATFOR that one of the most important geopolitical dynamics of the coming century will be finding efficient substitutes for traditional hydrocarbons. This is not rhetoric. This is not environmental propaganda. The country that masters these new sources of energy will exhibit dominance in the century to come.
On a brief side note, you can read Mr. Friedman’s brief forecast for the next 100 years here. That article is a year old, but we’re talking about the next 100 years, so it’s still fairly relevant. He also wrote a book, The Next 100 Years, that covers these predictions in greater depth. I found it fascinating, and if you like thinking about big picture concepts and crazy ideas, you’ll probably dig it too. On the other hand, if details are what matter to you and you spend most of your time thinking about the present and immediate reality, there are plenty other books you’ll find more interesting.
We’re at an interesting place right now with oil. Oil below about $80 exhibits positive correlation with equity prices. Most of that is purely coincidental, but some of that is causational; as people get wealthier and the economy grows, they demand more on energy. They’ll run their air conditioners in the summer and fly and drive more on vacation.
But when oil prices get too high, it hurts the economy. People adjust their thermostats and travel less, or pare back spending elsewhere in order to keep from having to ride their bicycle to work. As consumers are forced to devote a larger portion of their paycheck to energy, the rest of the economy suffers and the correlation with equity prices breaks down.
So as we watch crude oil together, let’s keep our eyes peeled for days and weeks where oil prices rise and equity prices drop (or vice versa). In particular, also watch for breakouts to new highs. With extremely little fanfare, we’re getting close to that happening.
Another oil shock would be disastrous for the economy. This time we won’t be able to borrow from our HELOC or run up our credit cards the way we did in 2007 to maintain spending on our cushy lifestyles. And this time policymakers will be hamstrung, tapped out on stimulus measures that have been directed elsewhere. If crude starts trading too far above $80-$85/barrel, things could get very ugly very quickly.
What might trigger that?
Possible catalysts
A lot of things could trigger a spike in crude oil, everything from instability in the Middle East to a new round of global speculation. Apart from another deflationary apocalypse, I’m having a hard time coming up with things that would trigger a collapse in oil prices. The supply/demand fundamentals at present are pretty good; there is plenty of crude oil out there right now and demand is weak relative to the supply. Even with that, oil still doesn’t seem to want to go down.
As I said, we’re not in the danger zone yet. But soaring crude could be one factor that sets up the birth of a new bear market. It could be the catalyst that reminds that markets that the fundamentals of our economic future are a mess.
In the meantime, trade it!
There are a bunch of ways to trade or invest around this thesis, guarding against possible oil shock. On top of that, you can take advantage of all the seasonal forces in the energy markets during this time of year.
The most direct way is via the futures market. You can play crude oil directly, or even gasoline futures. Gas prices typically tend to peak in the late spring and early summer. Putting on a crack spread (long crude oil, short gasoline & heating oil) is very popular during spring, historically the strongest months of the year for energy-related investments.
Trading futures carry a lot of risk, and generally we tell people to stay away unless they really know what they’re doing. It’s easier and safer to use stocks or ETFs. You can buy refiners like Exxon, Royal Dutch Shell, and Chevron, or buying a basket of energy companies through an exchange traded fund like the XLE. Investors with a little more sophistication can put on all sorts of great spreads and relative value trades to bring down risk and isolate your thesis a little more specifically.
Here’s a quick and dirty chart of average monthly returns for about the last twenty years. The data isn’t perfect, but it tells the same general story that energy stocks tend to outperform the market in the spring:
It’s still early March so there’s room to run. Memorial Day is a good time to take all these trades off. Selling in May (and going away) is a good idea for many of your investments.
Here’s a nice chart from the ever-excellent Calculated Risk, and you can see that growth in total miles driven has been slowing down. This is no surprise, as crude oil has become substantially more expensive in the last 5-6 years.
This should be a much better summer for driving, maybe the best we’ve seen in the last few years. You should expect higher gas prices this summer, and if that thought has you a little depressed, perhaps owning a stock like Exxon or an ETF like the XLE will help you out. These things can be a financial hedge, as they usually increase in value when crude oil and gasoline get more expensive, the gains of which could theoretically offset your increased driving costs.
They’re a good emotional hedge, too. Few things seem to piss off the public as much as rising gas prices, and in years past, I’ve found a lot of that anger was lost on me when I had energy stocks in my portfolio.
The Evil Speculators
One of my favorite stories of late is the one about the “secret dinners” that certain hedge funds have had where they gather ‘round in dimly lit, smoky rooms, wringing their hands between avaricious smirks, and discuss such nefarious plans as… shorting the Euro!
To people that understand the industry and can see through media spin, this sort of thing is comedy gold.
I laughed out loud at Jim Chanos’ hilarious (and correct) observation that if this was a story about a bunch of fund managers meeting in secret to discuss going long the dollar, buying up dollars against other currencies like the euro, nobody would care. Nevermind that it’s the exact same thing. I’m as critical of the media as anyone, but I have to abandon all that criticism when I remind myself that they’re in the business of telling stories. They’re very good at it, too.
A secret consortium of hedge fund managers conspiring to destroy Greece and bring down the Euro is a lot more fun to read about than a tiny Mediterranean country who simply borrowed and spent too much.
But Greek prime minister George Papandreou disagrees with me, and truly believes that these speculators are the cause of his country’s woes.
I understand that these politicians have to say or do something slake the thirst of their constituents. The last thing that we want as voters are elected officials who not only are impotent in office, but make no effort to act otherwise. If these guys seriously believe that a couple of fund managers are the reasons why Greece’s borrowing costs are more expensive than other countries in Europe, and they really think that these same all-powerful fund managers can singlehandedly force down the price of the Euro, a market that trades about $1 trillion every day, then we should all be afraid.
That would be a gigantic sign that these bozos don’t have a full grasp of the real problems over there. To me, that’s an even bigger signal to avoid the mess of Greece specifically, and the EU generally. Remember when Citigroup, Lehman Brothers, GM, AIG and sordid others all complained that speculators were the cause of their problems? Remember when they described their companies as completely safe & sound but were being unfairly attacked by villainous short-sellers? Yeah. Short-sellers were the least of their problems.
I’m sure it’s all just political posturing. I hope it’s just political posturing. But it’s a reminder that the people over there are still nervous, perhaps even scared. Fear is an emotional reaction. When we get scared, we point fingers. We leave our rationality at the door.
Based on how Greece has reacted to this crisis – a mess of their own making, mind you – I can assure you that they are freaked-the-hell-out over there. Riots? A conspiracy to destroy their country? Stolen Nazi gold? This country is clearly suffering from a fair amount of psychic trauma and the folks in charge need to act to address the fundamental problems. Otherwise the protests will go on forever.
Despite all this, I’m more optimistic about the situation now than I was a few weeks ago if for no other reason than Greek stocks appear to have put in a bottom. That’s telling us something. It sounds like France & Germany will keep Greece honest in forcing through some of these fiscal austerity measures in exchange for a more explicit promise of backing. That will help Greece with their most pressing problem, rolling over all the short-term debt that is now coming due.
But beyond that Greece still has a staggering amount of outstanding debt, a ridiculously low and corrupt tax base, and a budget that’s out of control. In the long run, their goose is probably cooked.
The strategy for Euroland is to manage the crisis and help Greece get through the next year or so. Right now there is legitimate concern of contagion. It wasn’t that long ago that all of Europe was panicked that the banks falling like dominoes in the U.S. would topple onto their home turf. It’s still a visceral memory and Europe doesn’t want that re-playing with its member countries instead.
So the hope is that over time it becomes more and more apparent that this is specifically a Greek problem, and not a general EU problem. If the markets become convinced that this is a problem unique to Greece, the senior European nations will feel much better about, or possibly even compelled to let Greece go.
It raises a very interesting two-dimensional question. First, is Greece still in the EU at the end of the year? Almost certainly. But are they still in the EU in 2015? I’ll let you answer that one on your own.
That brings me to the strong demand for last week’s Big Fat Greek Bond Sale. All sorts of lenders came out of the woodwork to buy those sparkling new 10-year Greek bonds yielding about 6.3%.
I have only two thoughts on that:
- Loaning Greece money for 10 years at 6.3%?! You can NOT be serious!? That has got to be straight up speculation. I mean, how is that not a completely speculative, short-term play?
- Where’s the love for speculators now? It’s OK for us to speculate and buy your dodgy debt but not OK to sell your currency short? Sheesh, Greece. I’m not sure we can still be friends.
(Seriously, though. Visit Greece if ever get the chance. It’s a beautiful country and a trip there might change your life. Just don’t tell them you run a hedge fund.)
Now that I’ve come full circle, it’s probably time to wrap it up.
The markets are sound asleep right now, having forgotten about the fiscal tragedy in Greece. So I’ll be spending the next week pondering about what the next catalysts could be, the items that swirl out of nowhere and cause the market to freak out. More often than not this business feels like a big game of Whac-a-Mole.
Any ideas? Any items out there that have you guys on edge? Let’s hear it at Feedback@TheDraconian.com. We can break it down together next Thursday.
Thanks for the feedback on last week’s newsletter – I’m glad you guys enjoyed it. If you happened to miss that one, you can catch up right here.
This week we’ll continue our conversation on taxes and show you exactly where all this money goes. Most of us get angry when we send that gigantic chunk of our paycheck off to the IRS, but we don’t always think about what happens to it after that. Perhaps we don’t because it would just make us more angry?
Today we’ll also talk about what to expect in the coming years and what you can do to protect yourself. Those who don’t understand how this all works and what our economy is up against are at a serious disadvantage. We’ll help you put together a toolbox that will boost your odds of surviving the decade that awaits.
Last week’s goal was to be informative, but today we make good on our promise to be useful.
Where does my money go?
Charts are always a nice way to answer questions like this:
It’s pretty simple.
Most of your money goes to four places:
- Social Security
- Healthcare
- National defense
- Interest on our debt
Does the rest of it even warrant being talked about? Probably not. At least not today. There’s a lot of noise about all the social programs and agencies and pet projects that the government has, but in the grand scheme of things it just doesn’t matter. Don’t get me wrong, these programs may be really important (if you directly benefit from them) or wasteful spending (if you don’t). But when we look at the dollars and cents of the big picture they don’t really move the needle.
This is actually part of the problem. Tell me if you haven’t had a similar exchange in line at the grocery store:
Me: mmm… orange Tic Tacs.
Tic Tacs: Yes, you liiike orange Tic Tacs.
Me: Do I really need orange Ti-
Tic Tacs: -YES! We are only $0.79.
Me: What the heck, they’re only $0.79 and so delicious!
When it comes time to tighten the federal budget, the little expenditures are the first to get scrutinized. That’s fine and all, but instead of worrying only about all the orange Tic Tacs I’ve purchased, I should really think about swapping filet mignon for hamburger every so often. OK, sirloin. A fair compromise, steak snobs?
Now imagine a nation of 300 million people who have elected 575 individuals to make thousands of decisions on their behalf. Not only are these guys constantly adding little expenditures here and there, but when it comes time to clean up the budget, these tiny expenses are the only things that actually get reduced. When it comes to the big stuff like entitlement spending all we get is rhetoric.
I might be a card-carrying libertarian (which in certain circles wins me immediate dismissal from the conversation) but I’m not too far gone into the land of every-man-for-himself ideals that I can’t assess the big picture without a bit of pragmatism. It wasn’t that long ago that I was in college, a time when knowing how to navigate pockets of honest-to-God socialists was an essential tactic for social survival.
Imagine for a moment that you lived in a country where you had to pay for your own healthcare and save for your own retirement.
Would our society be better or worse off?
(You don’t want to imagine life in the U.S. without such a military. The military gets kicked around a lot and often for good reason, but the reality is that the United States is the United States because of its military. No other factor comes close to enabling all that a dominant military can. I’m a fan of diplomacy too, but the world I live in is one where muscle is might. Whether I like it or not.)
What would the government do with a few extra trillion per year in revenue? Or how would individuals’ lives be different with dramatically lower tax burdens? What kind of new business would that environment attract? I’m not saying we should eliminate these programs completely, but these are interesting questions that can lead you in different directions on the political spectrum.
These are great programs, but you’ll see in a moment that we’re in a bit of a bind.
Closing the gap
Here’s the chart that will give you nightmares tonight. Those with delicate constitutions should scroll ahead.
Seriously, look at that chart again.
Let it soak in for a moment.
What unnerves me the most about this chart is how long it’s been since we’ve spent what we made. What kind of example does our government set for individual households? Or, does the government spend more than it makes because it’s composed of individuals who do the same? There’s a mindbender for you.
Note that increases in spending tend to quickly follow increases in revenue. Given what you know about politicians, that shouldn’t surprise you. As soon as they get a little money they spend it.
Perhaps that problem isn’t unique to just politicians, but rather Americans in general. If there’s a way for us to spend money and get a little enjoyment in the present, we’ll do it, regardless of the long-term costs & consequences. Right or wrong, this is way most of us are wired. There are good reasons for that but that’s more the domain of psychology. Though as the field of economics evolves, the line between those two disciplines blurs.
You’ll notice that chart really starts to diverge in the early 70’s, and you astute historians are probably smiling right now with the answer as to why. In 1971 the U.S. said goodbye to Bretton Woods and since then, without a gold standard to keep us honest, deficit spending has been the norm. Our government talks a lot about “pay as you go”, but you can see that they just aren’t wired to act in that way and there’s no monetary system in place to force them to.
Right now, the politically feasible solution seems to be to increase taxes on unpopular groups like the rich or the banks and cut (cut?!) taxes on everybody else. As we pointed out last week, the wealthy already pay most of the taxes in this country anyway, it’s just that the threshold for “wealthy” is a little lower than you probably guessed. I hear a lot of talk from the current administration about cutting taxes and a lot of talk about protecting or increasing benefits. Does nobody else recognize the unsustainability of that equilibrium?
That chart is the reality with which we are faced. An era of sacrifice has begun. Some will be sacrificing more than others, but all of us will need to chip in eventually.
In one way or another.
The truth about the tax code and the “inflation tax”
I mentioned that the tax code is incredibly complicated. The reason it’s so complicated is that it is used as a tool to shape social behavior. You don’t have to venture very far into the land of behavioral economics to discover that individuals respond to incentives, particularly financial incentives. And so tax breaks here and penalties there have the effect of changing certain behaviors that the government believes are in our collective interest.
Ultimately, the tax code is also a tool that politicians use to get elected. Voters like to elect politicians that promise them things, especially money. So the tax code gets amended and amended again to give certain freebies to certain folks, and the result is the 4 million word behemoth we have today.
Most taxpayers aren’t too affected by all the mumbo jumbo the IRS has published, but there is a sneaky tax that lives outside the tax code that everyone pays and no one can dodge: inflation.
You might be wondering how on earth the U.S. is going to reconcile that chart of diverging revenue and spending. It isn’t socially feasible to rely on tax revenues to get the job done. Contrary to popular belief, the government isn’t actually stupid. It knows it can’t just raise taxes on its people without political consequence. But here’s the clever solution: it borrows money to fuel spending right now and then pays back its lenders in the future with dollars that are less valuable than they were when the government lent them. The dollars are less valuable because there’s a lot more of them floating around.
You might not realize it but inflation is a hidden “tax” that we all pay. The government recaptures a few extra percent of our dollars every year via the monetary policy that it has chosen to adopt. If I put $1,000 under my mattress in 1900 and took it out today it would still be $1,000. The difference is that when I put it under my mattress it was an entire year’s salary and today it’ll buy me one month’s payment on my 4Runner and a robot vacuum. (This is the future, after all.)
What happened to that magnificent loss of purchasing power? It was inflated away but the powers that be.
Inflation gives us an incentive to consume, to exchange dollars for services, plasma TVs, and other stuff. It’s also an incentive to invest, to find riskier assets that return more over time than cash does.
The Fed slashed rates to less than 0.25%. It has purchased mortgage-backed securities and treasury bonds, forcing down interest rates to historically low levels. I can go out today and buy 1-year T-bills that yield about 0.3%. Inflation in 2010 will probably clock in somewhere north of a couple percent. My return after inflation is negative 2-ish percent. Why on earth would I do this? Why would I make an investment where I am guaranteed to lose money after adjusting for inflation?!
It’s nuanced discussion, but if you’re a normal person the answer is that you don’t do this. You run out and buy the stock market or higher-yielding corporate debt instead. Or maybe you spend it on a robot vacuum. This is exactly what Bernanke, Geithner, Obama, China, OPEC, and pretty much everybody else in the world wants you, the American Consumer, to do.
Maybe you’ve heard theories about how Alan Greenspan inadvertently created the housing bubble by keeping rates too low for too long. Maybe you’re wondering why the stock market rallied so much last year. Maybe you feel antsy about holding too much cash. Negative real interest rates may not have been the sole reason for those phenomena, but they were extremely powerful contributors.
Think about how you might rebalance your portfolio if your savings account paid you 3 or 4%. Imagine if 10-year treasuries nabbed you 5 or 6%. Think that’d be good or bad for riskier investments like stocks or real estate?
Rich or poor, every single one of you knows the answer to that question.
What to do about it
Our goal here at The Draconian is to be entertaining, informative, and useful. I haven’t a clue if we’ve been entertaining but I feel pretty confident that we’ve been informative. Now, here’s the “useful.” Here’s what you can do about all of this.
Buckle up for higher taxes.
You high earners out there really need to strap in and get your financial house in order. Focus on controlling the spending side of your personal income statement. There’s actually a wonky term out there to describe this phenomenon, “Ricardian equivalence”, a fancy-shmancy way of saying that if people are expecting to get taxed more down the road, they’ll save more today.
Those of you who aren’t high earners also need to get your expectations in line. The rich are an unpopular minority at present and it’s normal for them to be targeted first in an environment like this. But there are hard limits on the size of the burden they can shoulder, and soft limits on the point at which they begin to change their behavior in socially inefficient ways. It’s reasonable to expect that given the fiscal policy the U.S. will be forced to run during the next decade, the wealthy minority will not be able to do it all themselves.
Lower-earning households should prepare for sacrifices as well. For you guys it probably won’t come via a higher income tax rates, but it could through higher social security rates or more excise taxes. Lower-earning households benefit disproportionately from social welfare programs, and a slashing of entitlements is the way that those folks will probably have to sacrifice. Don’t be surprised to see your healthcare, state pension, or Social Security benefits scaled back. If you’re in one of those lower income quartiles that we talked about last week and you’re relying on government cheese to support your lifestyle, you will need to make some adjustments. At the very least, align your expectations appropriately.
I’ve talked about a VAT before on here, and this is a real discussion that needs to take place in Washington in the years to come. These types of taxes are considerably less progressive than the income tax. That’s a fancy-shmancy way of saying that they impact the poor the most.
In time, everybody will feel the effects of inflation as well. There are ways to avoid the “inflation tax,” but you have to be clever and read awesome newsletters like The Draconian. By virtue of reading a newsletter like this one, you guys get a substantial leg up on your peers (I’m not joking).
I frequently mention books and other blogs in this space, and these are other resources that will help you out in your battle to survive the challenges of today and tomorrow. Check them out. If you think a static page of books and blogs that we recommend would be beneficial, let me know at Feedback@theDraconian.com and I’ll put something together.
The virtue of saving
Remember that the number one rule in nasty recessions is conserve cash. Everybody loses in ugly environments like this. The winner is he who loses least, and he who loses least is usually the guy who had the most cash.
I know you’re all saving aggressively, but now it is even more important to do so. You need to save in such a way that taxes and inflation don’t wipe you out. Make sure you’re maximizing contributions to tax-deferred accounts. When you’re investing, make sure you incorporate inflation-sensitive assets like Gold and TIPS into your portfolio. We’ve talked about all the ways you can do that many times before, but GLD and TIP are as easy as it gets.
Work with a skilled accountant (or use TurboTax like Tim Geithner!) to make sure you aren’t paying more than you should and are taking advantage of all the weird incentives the tax code has given you. I don’t understand all this IRS stuff and it changes every year, but that’s what I pay my accountant for.
I have a pretty good feel for the demographics of our readership. I know that this letter goes out to a disproportionate percentage of high earning, high net worth individuals. I’m sure a few of you others out there were surprised to discover “Hey! I’m actually wealthy!” So I hope what we’ve touched on in the last two weeks are some issues and questions that aren’t being discussed in more mainstream venues.
And I hope I haven’t left the rest of you behind. You may not have gigantic investment portfolios, but you have a unique advantage over your peers; you are intelligent readers. Keep reading and someday you too will find yourself in the wealthy bucket – for better or worse!
